Private equity thrives amid VC decline

Private equity thrives amid VC decline

Ontario’s recently appointed Minister of Research and Innovation Reza Moridi has a clear goal: to create new knowledge and commercialize that knowledge in order to create jobs and push the province further along the path to securing its place as a knowledge economy.

Achieving that goal will take money — specifically, risk or venture capital. To help inject much-needed funds into the province’s venture capital coffers, the government has just created a second $50-million venture capital. The first, launched in 2008, attracted $750-million in private-sector investment and created 1,500 jobs. He’s hoping to emulate that success with Ontario Venture Capital 2.

“We are committed to this because there is a direct link from technology startups to improved competitiveness. Look at Microsoft, Apple, Google. They started as venture capital-backed startups,” says Mr. Moridi. “An innovation may seem simple but it can turn into a billion-dollar corporation. The potential is huge. But that potential can only be realized if you have venture capital available. Private equity has a role to play, too. But it typically helps later in the game. ”

The potential is huge. But that potential can only be realized if you have venture capital available

And that highlights the fundamental difference between venture capital and private equity: The former invests in potential while the latter invests in the tried and true. More specifically, venture capital is largely focused on new and emerging technologies with no track record. There are no financial statements at the time that 95% of venture investments are made. The goal from the venture capitalist’s perspective is to build the business from the ground up and get it growing in order to exit, ideally via a blockbuster IPO. Private equity invests in existing companies typically in traditional industries such as oil and gas, mining, manufacturing and retail with existing products and cash flows, sales in excess of $20-million and positive earnings before interest, taxes, depreciation and amortization. The goal with a private equity investment is to restructure a company to optimize performance in order to make it attractive for sale or an IPO within three to five years.

With Canada’s reputation for being risk averse, perhaps it’s not surprising that while venture capital funds have struggled since the tech bust, private equity continues to grow hitting its highest level in four years in 2012 with 313 deals worth $11.6-billion and $60-billion under management. In fact, the Canadian private equity industry has been incredibly successful and its returns over the past three, five and 10 years are among the best in the world, says Richard Remillard, executive director of Canada’s Venture Capital and Private Equity Association. “That in part explains why so much capital has gone there.” Meanwhile, venture capital funds in Canada remain anemic, nowhere near tech-bubble levels, with just $20-billion under management. In 2002, there were 56 active technology venture capital funds in Canada with greater than $50-million under management. Today there are fewer than 10. Part of the problem has been the stunning lack of exit opportunities. In 2012, there was one IPO of a new venture-backed company in Canada.

Derek Smyth, managing director of OMERS Ventures, which invests in high-growth companies in technology, media and telecommunications, remembers the flush days of venture capital well and feels too much money led to bad management decisions paving the way for today’s tightened situation. “I was raising money in the late 1990s both as a technology operator and venture capitalist and benefited from Canadian and U.S. sources of capital. I know there is considerable jungle drumming about the fact that we had all this venture capital and now we don’t and that must be the problem when it comes to a lack of funds for startups. I don’t see it that way. There was too much venture capital in Canada in the mid to late ’90s chasing the bubble, too many unqualified people came into the business and all they were doing was writing cheques, not providing value to the companies and as a result the returns on most of those venture capital funds were not good enough to get support 10 years down the road,” he says. “The great venture capital firms in North America bring money, but the bigger value proposition is a network, a portfolio of companies that are synergistic, operating experience that allows them to help both strategically and tactically in the business.”

Mr. Smyth also thinks it’s time that entrepreneurs take a hard look in the mirror. “There is plenty of data to show that great companies get funded. I can’t think of a company that did not make it in the last nine years because the funding wasn’t there.” He points to Waterloo, Ont.’s Desire2Learn as an example. A global leader in Cloud-based learning solutions, it attracted $80-million, the largest single first round of venture capital funding in the history of Canada from New Enterprise Associates (NEA) and OMERS Ventures.

There is plenty of data to show that great companies get funded. I can’t think of a company that did not make it in the last nine years because the funding wasn’t there

The private equity industry really took hold in the last decade — just as venture capital began its downward spiral. When you look at private equity, it is later-stage investing in companies with a five- to 10- year history, track records and a challenge to management of some sort. Technology hasn’t been a subject of too much interest for private equity funds until recently. Rather, management is looking for a partner to help them grow or take them private or spin off a division. The goal for the private equity investor is to come in, address any issues and sell quickly. “If you have a business that is sub $10-million in revenue, you don’t have a chance to get private equity. It’s not happening,” says Mr. Smyth.

“On the venture side, we are investing in companies that are not making money and will continue to lose money for some period of time. We are investing in a combination of exciting large markets, a strong team that has the ability to develop IP and exploit those markets. We help them establish themselves in the market, build topline growth with the goal of going from $1-million in sales to $50-million to $100-million in three to five years. The growth curves are really steep and make up for the early years of losses very quickly. The ones that succeed become high growth businesses.”

But it takes time, on average up to 10 years, before that kind of success happens, says Mr. Smyth. “Facebook was in business 10 years before it went public. Venture capital is really hard. It’s not like spreading money around and a forest will grow. It is a roll-up-your-sleeves business and if you want to be successful you need to dig in with the entrepreneur and live through their ups and downs over a 10-year relationship.”

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